Paced by California and Illinois, state governments across the country continue to mimic the unsustainable fiscal excesses of the federal government – creating crushing deficits and soaring unfunded liabilities. Moreover, any state attempting to plug these holes with tax hikes or other revenue enhancements could create an exodus of businesses and taxpayers – meaning fewer jobs, lost revenue streams and diminished political clout.

It’s a delicate if not impossible calculus for states with large shortfalls – and a cautionary tale for states facing smaller deficits.

With the exception of Vermont, every state in America is required to submit a balanced budget. Many have refused to do so, however – resulting in mountains of unpaid bills, rising tides of red ink and widening chasms of never-to-be-kept promises.

During the 2010 fiscal year, states reported a record $191 billion in deficit spending. Another $300 billion in red ink is projected over the coming two years, according to the Center on Budget and Policy Priorities. Not only that, a July 2010 report published by the National Center for Policy Analysis estimated that state pension plans are underfunded by a combined $3 trillion – more than three times the amount that states are reporting.

How did things get so out of hand? Similar to the ongoing fiscal implosion at the federal level, one of the root causes of state insolvency is the unnecessary, unsustainable spending that preceded the economic downturn.

State and local spending soared from $1.74 trillion in 2000 to $2.66 trillion in 2007. Even after adjusting for inflation, that’s a 23.7 percent increase – which is comparable to the increase in federal spending over the same time period. Also, inflation-adjusted state spending in the seven years prior to the recession grew more than twice as fast as America’s population during the entire decade.

Yet while American families and small businesses were forced to cut back when the economy sputtered, politicians kept right on borrowing and spending. Now, as economic growth continues to lag and so-called “stimulus” funds begin expiring, the costs associated with a decade of unprecedented fiscal recklessness are assuming imposing dimensions.

In California, politicians must cover a $28 billion shortfall over the coming 18 months. On top of that, the state owes a combined $25 billion to its employment insurance fund and to local governments it has borrowed money from in the past. Additionally, a report from Stanford University recently estimated the state’s pension fund shortfall at half a trillion dollars.

In Illinois, things are even worse. There, the current deficit accounts for more than half of the state’s annual budget – easily the highest percentage in the nation. Of course the “cure” could be worse than the “disease” for these borderline insolvent states – particularly if extricating themselves from the consequences of their bad decisions puts them at a competitive disadvantage with their neighbors.

Earlier this month, Illinois’ lame duck Democratic legislature voted to raise the state’s individual income tax from 3 to 5 percent while raising corporate taxes from 7.3 to 9.5 percent. Almost immediately after these tax hikes were announced, the newly-elected governor of neighboring Wisconsin – which is facing a comparatively manageable $3 billion shortfall over the next two years – unveiled an aggressive tax-cutting campaign aimed at luring Illinois businesses to his state.

“The contrast between the choice we’ve made and the one they have (made) is stark,” Daniels said, pointing to recent spending cuts that have softened Indiana’s deficit crunch. “They’ve been borrowing from the poor businesses that are suckers enough to do business with the state.”

He’s correct. In addition to its budget shortfall, Illinois has a stack of unpaid bills totaling $8 billion. The state’s unfunded pension liabilities are currently estimated at nearly $80 billion, and to balance its budget in 2012 a recent study estimated that Illinois would have to raise its corporate income tax rate to 11.3 percent, its sales tax to 13.5 percent, and cut spending by 26 percent.

Therein lies the dilemma for states that have plunged themselves into the abyss: How do they climb out without sending thousands of companies and millions of taxpayers scurrying to more favorable economic climates?

From 1910 to 1990, California’s share of the U.S. population nearly quintupled. Over the last two decades, however, that growth has slowed dramatically. After gaining only one seat in the U.S. Congress following the 2000 Census, California failed to gain a seat in the 2010 Census for the first time in ninety years. Illinois lost a Congressional seat in 2010 – after losing three seats during the previous two Census counts.

And based on their current state of fiscal disrepair, things could get even worse for these states in the decade to come – shifting jobs, investment and political power to states that have better managed their finances.

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